7 Important Behavioural Biases That Every Investor Should Know
It is common for people facing problems in life will avoid the situation by relying on quick judgments instead of rational thinking. The same happens in investing too. During challenging situations, investors start relying on their emotions and sentiments. But have you ever wondered how emotions-led decisions could risk your finances?
In this blog, we’ll learn about seven major behavioural biases affecting investors’ investing decisions.
Confirmation Bias
Confirmation bias is when investors give emphasis to ideas confirming their beliefs and understating ideas contradicting their beliefs. Suppose there’s an individual, say X, who believes mutual funds are a better option than stocks for investment. Now, X will always look for information that justifies his feelings about mutual funds. Hence, confirmation bias is X’s unexplained inclination toward mutual funds and negative emotions about stocks. As a result, investors can make wrong investment decisions. Hence, it would be better to consider all the different aspects before finalising any investment option.
Familiarity Bias
Familiarity bias explains that investors give importance to ideas they’re familiar with and always tend to prefer “known” or “safe” over the “unknown” or “unsafe”. The main reason for familiarity bias is investors want to avoid losses and stick to their comfort zones. Familiarity bias leads to losing better investment opportunities and inadequate diversification of the portfolio.
Herd Mentality Bias
Herd mentality bias refers to when investors tend to make investment decisions that align with the herd (group members). Here, investors are influenced by the emotions/preferences of others rather than rational or independent analysis. It happens because it is unfavourable to investors to go against the crowd. Peer pressure may be another reason. Herd mentality may result in high volatility in the market and inadequate research leading to inappropriate investment decisions.
Recency Bias
Recency bias is when investors rely on recent events in the past to make investment decisions in the present or future. For example, let’s say X’s investments were affected adversely due to a recent stock market crash. Though his losses got covered when the market recovered, he resisted investing in stocks in the near future out of fear of losing his money. This time he decided to choose debt investments over equity even if the likelihood of equity investments giving higher returns than debt is high.
Endowment Bias
The endowment effect is a psychological bias that leads people to overestimate the value of things they own, frequently irrationally, compared to their market value. The endowment effect is a term used in behavioural finance to describe a situation where a person values something they currently own higher than they would if they did not already own it.
Loss Aversion Bias
We all hate losing money. Loss aversion bias also called as Regret Aversion is when an investor prefers to avoid losses than make the same amount of gains. For example, X had to choose among two decisions. He can either decide to avoid a loss of Rs. 500 or make a profit of Rs 500. Like most people, he chose to avoid loss rather than making a profit of Rs.500.
And that’s why people are reluctant to sell stocks they own, even if the stock’s price has fallen below its purchase price. Many investors hold on to stocks for a long time in the hope that their share price will rise back up to what it was when they first bought them. They do it to avoid losses.
Self Attribution Bias
Self-attribution bias refers to when investors give due credit to themselves in times of success but blame their surroundings (factors out of their control) in times of failure. For example, investors start appreciating their stock-picking skills when the stock market performs well. But when a stock doesn’t perform as per expectations, investors start blaming factors like the inability of directors and so on.
Conclusion
The key takeaway here is that people do not make rational decisions in investing. Most investor behavioural biases fall into two main categories: cognitive and emotional. You can manage the cognitive biases by ensuring you have a well-diversified portfolio, etc. But the emotional biases are more difficult to manage, as humans are heavily predisposed not to act in a rational manner when it comes to investment decisions.
